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If you’re signing up for life insurance coverage, one of the last but most crucial decisions you’ll need to make as a policyholder is deciding how you want your beneficiary to receive the funds from your death benefit. These are commonly referred to as your “life settlement options.” This decision must be made regardless of whether you have a whole life insurance policy or some other form of life insurance.
To help easily understand this we broke down the five major types of life insurance settlement payout options below:
- Interest Income Option
- Life Income Option
- Specific Income Option
- Fixed Period Options and Fixed Amount Option
While a lump-sum payout is still the most traditional way in which to disburse your life insurance proceeds, that doesn’t necessarily make it the best option for you and your loved ones. This is particularly true if you want to divide funds between primary and secondary beneficiaries, or if you want to provide some manner of guardrails or parameters on how the money may be accessed over time.
To ensure you and your loved ones are getting the most of your life insurance policy, we recommend properly understanding your life insurance settlement options.
1. Lump sum option
A lump-sum payment is the most common form of life insurance settlement. With lump-sum payments, the insurer pays the entire death benefit of the policy all at once, income tax-free. The beneficiary is entitled to spend the money however they want, including investments, or rolling over the funds into their own life insurance policy.
There are, however, a few cases in which the beneficiary will not receive the full policy’s death benefit. If the policy owner has existing debt — such as credit debt or any other amount due to creditors — this amount will be deducted first.
Similarly, In the case of permanent and whole life policies where loans may be made against any built-up cash value of the policy, the payout amount will be reduced by the outstanding balances first.
2. Interest income option
In an interest income option, the proceeds of the death benefit are temporarily held by the life insurance company, and incremental amounts are paid out based on interest earned from the original death benefit. The insurance company holds the rest in a separate account. This option is good if you want the principal to be held safe for a later event (such as college tuition), or you wish to split the interest payments and principal among a primary and secondary beneficiary (for instance a child and grandchild).
Say the value of your policy is $100,000, and you have negotiated a 5% interest rate with the insurance company, the beneficiary will receive $5,000 a year for the specified time period, such as a ten-year period. This amount can be broken up to be monthly, quarterly, semi-annually, or annually.
When the specific period of time is over, the designated beneficiary can then receive the remainder or full amount of the proceeds. This is the death benefit and not the cash surrender value, and it will not be counted as taxable income.
The interest rate and length of time must be negotiated with the life insurance company, but they are generally competitive. However please note: Unlike a lump sum, you must pay taxes on any interest earned on the principle of the policy, which can be sizable if the death benefit is high. Be sure to calculate your payout over time to decide which makes the most sense.
3. Life income option
A life income option means that instead of the beneficiary receiving the amount of the death benefit, they lock in a guaranteed monthly payment for the rest of their life.
While guaranteed income for life may seem like a lucrative deal, the monthly amount is determined by the life insurance carrier based on the value of the life policy and the age and life expectancy of the beneficiary. This will largely be equivalent to the total death benefit.
In some cases, if the beneficiary lives longer than expected, they may receive more than the face value of the original life policy. However, once the primary beneficiary dies, the life insurance company ceases payments — even if there’s remaining value on the policy. These do not pass onto a secondary beneficiary.
The real benefit of the life income option is to provide a financial structure that will always provide income stability and regular payments for the beneficiary, and cannot be used up in a single purchase, or lost in a single financial downturn.
4. Specific income option
The specific income option pays out the same regular payment amount for a number of years until the value of the policy is fully paid out. Interest is accrued on the remaining amount of the principal while it’s still unpaid, however, taxes must be paid on any amounts earned through interest. Unlike the lifetime option, if the primary beneficiary dies, a contingent beneficiary can be chosen to receive the payments on their behalf.
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This option combines the financial guard rails of a lifetime payment with a more finite certainty on the total amount that will be paid out.
5. Period certain and fixed amount options
Fixed period and fixed amount options both pay regular installments to the beneficiary either for a certain period of time or up until a certain amount is reached. In both cases, interest is earned on the remaining principle held by the life insurance company, and contingent beneficiaries are eligible to receive the remaining payments in the event the primary beneficiary passes. Most payouts of this sort will come with a disclaimer guaranteeing that they will receive at least a certain minimum amount.
Special case: Joint and survivor annuity
An annuity is similar to life insurance, except instead of a payout being received upon death, a series of fixed payments begin at a specified time period until the death of the insured.
Generally, annuities are purchased by individuals who are worried about outliving their retirement funds, and as such annuities are purchased by individuals between the ages of 55-80, compared to life insurance which tends to be purchased between the ages of 25-50.
In a joint and survivor annuity (also known as a “joint-life annuity”), a payment plan is made such that regular payments continue to be made so long as either insured person is alive. This is typically used by couples when there is concern one individual may substantially outlive the other.
In the case of a joint and survivor annuity, the cash payments from the annuity will typically decrease once one of the insured individuals is no longer living. For instance, if the annuities are $6,000 when they begin, they could reduce to $3,000 when one of the policyholders passes. A joint and survivor payout will require underwriting on both spouses in most cases.
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Just like there is no “best life insurance” there is no best type of life insurance settlement option. It all depends.
The primary factors to consider are the speed and regularity with which payments will be dispersed. Don’t hesitate to consult with your life insurance agent if you have any questions.
Want to find out how much you could sell your life insurance for? Try our instant life settlement calculator for free.